It took the FTSE 100 more than 16 months to recover from the Lehman Brothers collapse – it wasn’t until December 2009 that the index returned to levels not seen since the bank went under in September of the previous year.
The gradual return of the index to something approaching pre-2008 levels has been undoubtedly a welcome relief, but for many savers and employers, both the financial and the psychological damage will take much longer to recover from.
The effect of the seizure at the heart of the financial system proved to be as drastic as anything in living memory for all but the very oldest pension savers. Pension funds already blighted by market collapses at the start of the century were ill-prepared to endure yet another trough and the nation’s final salary schemes plunged to their lowest ever funding levels. The Pension Protection Fund reported total defined benefit (DB) deficits of £209.6bn in December 2008, while Aon Consulting’s DC index found that the average projected annual retirement income for a 30 year old has fallen by £3,197 as a result of the credit crisis.
As a result the pensions landscape has altered irrevocably since Lehmans’ collapse back in September 2008, leaving government, pension providers, advisers and individuals facing an uphill battle to ensure we have a decent level of income in retirement.
DB plans, which were already an endangered species, are now disappearing at an even faster rate and even existing members are no longer able to take their final salary provision for granted.
Bob Scott, partner at consultant Lane Clark & Peacock, says: “An awful lot has happened in the last two years and there has certainly been a huge change in the financial landscape. Every day companies are closing DB schemes to new and existing employees and increasingly companies are looking to secure their pension scheme by passing liabilities to the insurance market.”
In the public sector, too, final salary pensions are under threat after the new coalition government wasted no time in commissioning a review of public sector pensions with a view to reducing the now pressing multi-billion pound strain on the public purse.
While the DB sector is shrouded in gloom, David Felder, trustee at independent trustee firm Law Debenture, believes the crisis has at least prompted a long overdue assessment on the unmanaged risks carried in these schemes.
“Lehman itself had a moderate impact on pension funds but the shockwave it set off had a big impact. The crisis led pension funds to think about how they approach risk management which means looking at their exposure to counterparty, market and investment risk,” Felder says.
Hedging techniques to remove unrewarded inflation and interest rate risk are becoming more commonplace among DB plans, and trustees are more inclined to consider liability-driven investment strategies. Where funds are exposed to counterparties, the risks are explored fully with appropriate collateralisation arrangements put in place.
Scott says: “The behaviours of companies and trustees have tightened up post-Lehman. People are certainly much more aware of the possible counterparty risks and they look very carefully, even more than before, at putting money on deposit and at the underlying assets in so-called cash funds.”
He adds: “They are simply generally more wary across the board and are looking to diversify their risks and not leave themselves exposed to potential losses if we were to have another Lehman.”
Although the Lehman’s collapse has been far from beneficial for DB schemes, it has resulted in a much needed focus on risk management, with trustees and sponsors anxious not to repeat the mistakes of the past. However, in the defined contribution market, where savers do not always enjoy the protection of a trustee board and individuals often lack access to individual advice, many investors are still exposed to the risks inherent in their plans.
Duncan Howorth, managing director at JLT Benefit Solutions, says: “We still have a problem that DC is the poor relation; DB is where all the money and attention go. The flows to DC are growing by the month but it doesn’t command the level of attention that it should and it remains an outstanding challenge for industry to better serve the needs of members by providing better investment choice, protection and more suitable products.”
Inevitably attention has turned to the default design and the level of equity risk to which individuals were exposed. In some cases DC plans were invested almost exclusively in the global stock markets and while scheme members may have been willing to accept some falls along the way, watching their funds plummet by 40 per cent may have been a step too far.
“We had a DC machine where people were largely invested in equities either through managed funds or directly in tracker funds,” says John Lawson head of pension policy at Standard Life. “People got a huge shock when the value of their pension fund fell by 30 or 40 per cent. I think that taught us a big lesson in terms of the governance of DC, particularly of the default funds.”
Lawson argues that the received wisdom from the “clever guys in the City” regarding the long-term outperformance of equities does not always sit comfortably with the expectations and risk profile of the average DC investor. Where an institutional fund manager may long for astronomical returns, happy to endure the volatility this brings, the typical pension investor wants something more stable and predictable.
He says: “It’s about setting expectations at an appropriate level. It’s better to surprise people with good performance than to disappoint them with bad performance. That is a key lesson for DC schemes now. I don’t think members want stellar returns – they want a reasonable return, and we’ve got to understand that that is what the consumer really wants.”
The role of the default is critical since the level of apathy among DC savers, irrespective of the chaos on the financial markets, remains high. The fallout from Lehman’s collapse may have caused members to digest their statements with a rising sense of concern, but relatively few were prompted to do little more than ask questions of their employer.
Robin Hames, head of technical marketing and research atBluefin Corporate Consulting, notes that corporate clients have since asked for more education to be built into products, something Hames says would both manage employees’ expectations and prevent any knee-jerk fund switching which may be to the saver’s detriment.
“Employers were looking for us to do more education as members were looking at their statements more often. We would more than likely have done it anyway, but we built more education into the Orbit [flexible benefits] platform as those users are the ones who look at their funds more often and take a more active interest. If they are in the default and likely to see falls, we need to get more information out there and make sure they think about decisions before making them,” he says.
Following the financial crisis the Organisation of Economic Cooperation and Development (OECD) commissioned a review of DC default strategies, with a view to providing foundations for “carefully designed regulations to limit investment risks in default options and help avoid situations where older workers and retirees are exposed to major losses of retirement income”.
Reporting in June, the OECD found that lifestyling and dynamic derisking emerged as possible contenders for a model that both protected savings and was easy to understand, although their success was dependent on how savers took their retirement income.
Pablo Antolin, a lead author of the OECD, report says: “We found that life-cycle strategies do best when benefits are paid as life annuities and are less valuable when benefits are paid according to a predefined logic that might use up a part of the capital.”
He adds:”On the other hand, dynamic strategies work better with predefined withdrawals, though a mixture of life-cycle and dynamic strategies may be required when benefits are to be paid through a combination of predefined withdrawals and deferred life annuities bought at the time of retirement.”
The value of lifestyling, however, remains up for debate with some commentators arguing that the strategy came into its own following the financial crisis, protecting retirees from catastrophic losses at the worst possible time.
Lawson says: “One positive is that stakeholder has driven default funds and so many funds had lifestyling in them which protected the majority of people approaching retirement. We had risk mechanisms in place, having learnt from previous crashes, so those near retirement were protected.”
In contrast, Hames notes that for anyone made redundant or forced to take early retirement as a result of the market crash, the picture was quite different. The likelihood is that someone who lost their job in their 50s, who expected to retire at age 65, would still have been heavily invested in equities just at the wrong time.
Hames says: “How many people found themselves ’retired’ earlier than they were expecting or wanting? The critic of lifestyling has to question whether derisking occurred early enough to protect those laid off in a recession?”
However, both Hames and Lawson agree that more can be done to improve lifestyling by looking at derisking strategies sooner or taking greater account of a member’s specific circumstance.
Making private pension provision attractive hasn’t fallen entirely to the industry and although providers and advisers take the lion’s share of responsibility, government is also working to make the market more flexible and appealing.
Grappling with a £156bn deficit has forced the coalition government to embark on swingeing austerity measures, with the tremendous drain of state pension provision a key target. The change of government has brought with it an unprecedented amount of change in the pensions arena, which has been amplified by the need for drastic thinking to deal with the drastic problems caused by the credit crunch. Suddenly anything is possible in the world of pensions. Alongside money saving measures such as raising state retirement age, the administration plans to bolster the private sector by removing forced annuities, reversing the previous government’s abolition of higher rate tax relief on pension contributions, scrapping the default retirement age, introducing auto-enrolment in workplace plans, and is even considering allowing savers access to pension savings before they retire.
Tom McPhail, head of pensions research at Hargreaves Lansdown says: “The unifying themes here are deregulation, personal responsibility and re-engagement. Investors are being presented with a pension system that encourages them to take an interest in their retirement plans, knowing that they will be treated fairly by the government and rewarded for their thrift.”
As well as endeavouring to make the retirement market more attractive, government is attempting to restore confidence by improving regulation of those financial institutions so heavily responsible for the collapse.
The Financial Services Authority (FSA) – heavily criticised for failing to crackdown on poor banking practice – will be disbanded in 2012 and no longer have jurisdiction over the banking sector which will instead be regulated by the Bank of England. Additionally, a Consumer Protection and Markets Authority will oversee the retail and wholesale financial markets.
In the meantime however the FSA remains in control and will push through changes from the retail distribution review and has pledged to take a tougher stance on financial malpractice.
Howorth says: “I think giving supervision of banks back to the Bank of England is right and I support that. But right now it remains difficult; all we’ve got is messages from the FSA saying it will be more intrusive, which is an inevitable reaction to former light touch regulation, but the test is whether that intrusion focuses on right things while still allowing businesses to function. Time will tell as to whether we get too much prescriptive rather than principles-based regulation.”
The collapse of Lehman Brothers and the ensuing financial chaos of the last two years have changed retirement saving in the UK forever, but not all change has been for the worse. A greater appreciation of risk and better tools with which to manage exposure have to be seen as positive outcomes, while a more dedicated focus on the individual and their saving needs has been a long time coming.
What matters now is providers and advisers keep up the momentum to ensure pension scheme members achieve some benefit from innovation while confidence is restored in long-term saving.